Companies aim to make a profit by selling products to their customers. These companies set their selling prices at a level to recover their costs and earn a profit. The costs these companies intend to recover include material and labor expenses and overhead costs. Manufacturing requirements determine the material and labor costs of each product. Companies use a base overhead cost recovery method to determine what amount of overhead costs to include in the product cost.
Direct manufacturing costs refer to the materials used directly in the product and the labor expense incurred to convert those materials. Base overhead expenses include those costs that manufacturing facilities incur in addition to the direct costs. These costs include labor costs of nonproduction employees, facility maintenance expenses or insurance expense. The company experiences these costs throughout the year regardless of the quantity produced.
Cost Recovery Definition
Cost recovery occurs every time the company sells a product to a customer. The total sale represents a recovery of the direct costs first and then recovery of the overhead costs. Once the company recovers all of the overhead costs, the company begins realizing a profit.
Cost Recovery Purpose
The purpose of cost recovery involves earning enough money to pay all of the company's expenses before recognizing any profit. The company determines its profit by subtracting its expenses from its total revenue. Before the company recognizes any profit, it must recognize enough income from its sales to pay all the costs incurred. Many overhead costs are fixed and the company needs to recover the entire amount of these expenses before recognizing any profit.
Cost Recovery Process
The process of cost recovery involves setting the selling price and selling products to customers. As the company sells more products, the sales revenue recovers the direct costs and the overhead costs. The selling price needs to be high enough to recover all costs of the product, including both direct costs and overhead. The company starts by determining its total overhead costs for the year. It maintains a balance of the unrecovered overhead costs. As each sale occurs, it reduces the unrecovered base overhead balance. This process continues until the company recovers all base overhead costs.
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